Climate change is “the biggest market failure the world has seen” (Stern 2008), with wide-ranging implications for stability – financial, economic, political, social, and environmental. As estimates of the economic consequences of climate change continue to grow, financial markets and business leaders face increasing pressure to factor climate risks into decision making. Climate change will hit markets from all directions. In boardrooms and at AGMs, what were once token whispers of eco-marketing have become serious discussions of extreme weather events, reputational risks, activist movements (shareholder and consumer), regulatory and transition risks, asset stranding, and environmental litigation. In response, investors and regulators are calling for climate risk disclosures and a clear demonstration that portfolios and business models are consistent with the Paris Climate Agreement. Central bankers, finance ministers, the International Monetary Fund and United Nations are in on the action.
Such enthusiasm for ‘greening the financial system’ is welcome, but a fundamental challenge remains: financial decision makers lack the necessary information. It is not enough to know that climate change is bad. Markets need credible, digestible information on how climate change translates into material risks. Instead, an explosion of ESG (environmental, societal, and governance) ratings and voluntary, ad hoc, unregulated climate disclosures has created a confusing world of unfamiliar, incomparable, and conflicting metrics.
A chief concern is the lack of scientific foundations in risk disclosures (see Fiedler et al., 2021). Climate models operate at global scales, projecting impacts over decades and centuries. Financial models do not. How should a high-frequency trading algorithm (operating in nanoseconds) adjust to the possibility that climate may reduce global output in 2100 by 10%? How should corporate disclosures address issues largely beyond their control, such as the carbon intensity of the national electricity grid, or the direction of government flood strategies? Most disclosures present companies as if they are independent of their physical (geographical) and macroeconomic surroundings. But climate change does not just affect firms individually, it affects countries and economies systemically. No corporate climate risk assessment is complete without also considering the effect of climate on sovereign bonds. Without scientific credibility, economic evidence, and decision-ready metrics, the field of green finance is open to charges of greenwash.
This is what motivated us to bridge the gap between climate science and real-world financial indicators (Klusak et al., 2021). We focused on a metric that is eminently familiar to financial decision makers: the sovereign credit rating. By linking climate science with economic models and real-world best practice in sovereign ratings, we simulate the effect of climate change on sovereign credit ratings for 108 countries under three different warming scenarios (see Figure 1).
We were guided by a single overarching principle: to remain as close as possible to climate science, economics, and real-world practice in the field of sovereign credit ratings. We are the first to simulate the effect of climate on future sovereign ratings under multiple warming scenarios. We also provide initial estimates of the effects of climate-induced sovereign downgrades on the cost of public and corporate debt around the world.
Figure 1. Bridging the gap between climate science and financial indicatorsNotes: Blue boxes represent the status quo in climate science, economics, and sovereign credit ratings. Economic models translate scientific projections of temperature and precipitation changes into macroeconomic impacts (white box). Green boxes and arrows describe our novel approach to closing the remaining gap between climate economics and ratings.
Sovereign ratings are reported using a 20-notch scale, where AAA is ‘prime high grade’ and anything below BBB- is considered ‘speculative’ (or informally, ‘junk’). We convert this into a numerical scale and use a machine learning model to predict creditworthiness, training it on ratings issued by S&P (one of the largest credit ratings agencies) from 2015-2020. Next, we combine climate economic models and S&P’s own natural disaster risk assessments to develop a set of climate-adjusted data. We use these to simulate the effect of climate change on sovereign ratings. Finally, we calculate the additional cost of corporate and sovereign debt due to climate-induced sovereign downgrades (Figure 1, purple).
We focus on sovereign ratings because they are already used in a range of financial decision-making contexts (e.g. under Basel II rules, ratings directly affect the capital requirements of banks and insurance companies). They cover over US$ 66 trillion in sovereign debt, acting as ‘gatekeepers’ to global financial markets. Sovereign downgrades increase the cost of both public and corporate debt, influencing overall economic performance and significantly affecting fiscal sustainability.
We document three key empirical findings. First, in contrast to much of the climate-economics literature, we find material impacts of climate change as early as 2030. In one realistic scenario, we find that 63 sovereigns suffer climate-induced downgrades of approximately 1.02 notches by 2030, rising to 80 sovereigns facing an average downgrade of 2.48 notches by 2100. Figure 2 depicts the magnitude and geographical distribution of sovereign ratings changes, showing that the most affected nations include Chile, China, Slovakia, Malaysia, Mexico, India, Peru and Canada. More importantly, our results show that virtually all countries, whether rich or poor, hot or cold, will suffer downgrades if the current trajectory of carbon emissions is maintained.
Figure 2. Global climate-induced sovereign ratings changes (2100, RCP 8.5)
Second, our data strongly suggests that stringent climate policy consistent with the Paris Climate Agreement will result in minimal impacts of climate on ratings – with an average downgrade of just 0.65 notches by 2100.
Third, we calculate the additional costs to sovereign debt – best interpreted as increases in annual interest payments due to climate-induced sovereign downgrades – in our sample to be between US$ 22–33 billion under a low emissions scenario known as RCP2.6, rising to US$ 137–205 billion under RCP 8.5. These translate to additional annual costs of servicing corporate debt ranging from US$ 7.2–12.6 billion to US$ 35.8–62.6 billion in each case.
There are caveats. There are no scientifically credible quantitative estimates of how climate change will impact social and political factors, so these are excluded from our model (Oswald and Stern, 2019). Thus, our findings should be considered as conservative. Moreover, our results should be understood as scenario-based simulations rather than predictions. We do not comment on the relative probabilities of any given warming scenario playing out in practice.
The key take-home message is that existing climate science and economics are capable of supporting credible, decision-ready green finance indicators. Governments issue ever-longer dated bonds, of which life insurance companies and pension funds are eager buyers, thus enabling them to match their own long-term liabilities. Therefore, investors should consider the long-term creditworthiness of sovereign issuers. Currently there is no reliable yardstick for assessing sovereign creditworthiness beyond the current decade and this research fills this gap. Based on the methodology applied here future research could focus on developing ultra-long ratings not only for sovereigns but also for other issuers including corporates.
- Read working paper: Rising Temperatures, Falling Ratings: The Effect of Climate Change on Sovereign Creditworthiness
- Read news release: First ‘climate smart’ sovereign credit ratings suggest global warming downgrades as early as 2030
This research is supported by LetterOne and by the International Network for Sustainable Financial Policy Insights, Research and Exchange (INSPIRE). INSPIRE is a global research stakeholder of the Network for Greening the Financial System (NGFS); it is philanthropically funded through the ClimateWorks Foundation and co-hosted by ClimateWorks and the Grantham Research Institute on Climate Change and the Environment at the London School of Economics.
About the author
Dr Matthew Agarwala, Project Leader: The Wealth Economy
Matthew Agarwala, Economist, Bennett Institute for Public Policy, Cambridge. Learn more
About the author
Dr Patrycja Klusak, Affiliated Researcher
Dr Patrycja Klusak is a lecturer in Banking and Finance at University of East Anglia and an Affiliated Researcher at Bennett Institute for Public Policy at the University of Cambridge. Learn more
About the author
Dr Kamiar Mohaddes
Kamiar Mohaddes is a Senior Lecturer in Economics and Policy at the Judge Business School and a Fellow in Economics at King’s College, Cambridge.
About the author
Dr Moritz Kraemer
Dr Moritz Kraemer is an international economist and expert in credit analysis and economic policy. Moritz is Chief Economic Advisor of Acreditus, a UAE-based risk consultancy firm, and Independent Non-Executive Director of Scope Ratings, the largest Europe-headquartered Credit Rating Agency. He started his career as an Economist at the Inter-American Development Bank in Washington, D.C. before joining S&P Global Ratings in London in 2001, co-heading the firm’s Frankfurt branch (2013-2018) and recently the Sovereign Ratings Group’ Global Chief Ratings Officer. Moritz has been a prolific public speaker and thought leader in the field of ratings but was also heavily engaged in several far-reaching change management projects, interacting with senior officials in over 100 countries across the globe. Moritz holds a Ph.D. in Economics from the University of Göttingen (Germany). He studied Economics, Latin American Studies and Literature in Frankfurt, Southampton and San Diego. He currently teaches graduate courses at Goethe-University Frankfurt’s House of Finance and the Centre International de Formation Européene (Nice).
About the author
Matt Burke is a Senior Lecturer at Sheffield Hallam University, former Research Associate at the Bennett Institute for Public Policy and Doctoral Candidate at the University of East Anglia. His main areas of interest are in the application of computational techniques to contemporary problems in finance and economics.